Data-Driven Analysis for Young and Enterprising Minds

Fiscal Policy Part 2 – A Primer on Tariffs

If you haven’t been living under a rock for the past half year or so, you likely saw some variation of this headline on the news:

“Trade war heating up with China and/or the EU and/or Canada and/or Mexico!”

“Trump administration pressures Beijing to make trade fair”

“Business owners uncertain about their future after most recent tariffs”

“Business owners optimism showing after most recent tariffs”

If you noticed that these headlines seem to contradict each other, you would be correct! Tariffs are trade actions are all over the news, and don’t seem to be showing any signs of slowing down. What exactly this means for U.S. and Global commerce, like all specific things in economics, is evidence-based and remains to be seen. However, in this post, I will discuss the basics of tariffs; why they exist as a tool of fiscal policy, some applications of tariffs and quotas in the past (both good and bad), and some general economic application of this kind of policy in today’s context. And, as a bonus, I’ll also talk a little about a political theory that has application with this topic, Dependency Theory, and why it matters in the environment that is most suited for tariffs to take place.

Let’s start with the basics. What are tariffs?

Tariffs are essentially a way for a domestic government to make the prices of foreign goods more expensive, to achieve the goal of protecting domestic industry from foreign competition. When you hear the word “Protectionism”, tariffs should immediately come to mind. Tariffs are most often used to prop up domestic industry that cannot yet support itself financially when faced with much larger global competitors. Think of a nascent company in a mature industry, such as Tesla competing with Toyota or GM, or Venezuela’s oil company competing with Saudi Arabia’s. These are perfect examples of companies that are tapping into a big, rich marketplace, but are new and lack the capital or reach to compete effectively.

The way tariffs work is relatively straightforward. The domestic government will see that domestic industry needs to charge higher prices than foreign competitors, and will tack on an additional tax (the actual tariff) to those foreign companies when they want to sell their goods to the domestic economy. In theory, this raises the price of foreign goods up to or just below the price of the domestic goods. Since prices are now equal in the domestic market, consumers have less incentive to not buy domestic, and producers and governments can appeal to consumers’ patriotism to make them buy more out of the domestic market. In theory, this props up domestic employment and reduces exports.

Sounds good, right? Don’t get set on the idea just yet. For all the upside, there’s a whole lot more downside. The following series of paragraphs will address some of the problems with tariffs, from multiple points of view, followed by criticism of each paragraph. I apologize for the dryness in advance, but it’s interesting stuff, and if you understand both the good and bad sides, you will know more than many in government today.

First, there exists in macroeconomics a concept called “Crowding Out”. This is most commonly used to chastise government spending as a way of stimulating demand. Raising government spending levels necessitates more government borrowing, which raises interest rates as more bonds are issued. Since big governments like the U.S. can essentially spend as much money as they want, and their bonds are seen as ‘safer’ investments, huge demand for government bonds is created when interest rates rise. Money that would otherwise go toward more productive assets, such as corporate bonds or common stocks, instead goes toward government bonds, where it is theoretically safer, but does not contribute as much to private sector activity. In other words, private sector investment is “Crowded Out” by government investment. Many people think this is a leading contributor to the slowdown of western economies’ GDP in recent decades.

Now, let’s apply the concept of Crowding Out to tariffs, in the context of the modern United States. Ours is an economy with an enormous amount of Demand, coming from a multi-million-person population with a high amount of disposable income relative to other countries. But as wages stagnate, the demand of the U.S. will shrink as fewer and fewer people have access to more disposable income. Considering this macro issue, let’s assume that Demand in the U.S. is flat, and while it is high, will not rise unless acted on by a massive force. Consumers naturally try to access the highest quality product for the lowest cost, so they will buy more foreign goods while they are cheaper, and more domestic goods from companies that can compete on price. If prices of goods rise enough, then consumers will have to adapt while their income is stagnant. I would think this adaptation means simply buying less stuff, both foreign and domestic. In this way, even though tariffs are meant to stimulate demand for domestic products, that demand is Crowded Out by consumers’ need to save their money.

Second, tariffs fly in the face of fundamental concepts of free trade, such as Competitive Advantage. Competitive Advantage is the flip side to the consumer demand trend shown above, where economies will specialize in industry where they have an advantage relative to their peers. We see examples of this everywhere, all the time, from Software Technology hubs in the U.S. (due to our world-class university system and earning power) to Oil Drilling in the Middle East (due to their overabundance of natural resources) to Call Centers and Textile Manufacturing in India and Bangladesh (due to their dual characteristics of a massive population that is relatively poor and can perform cheap labor), all the way to exports of Chocolate from Ghana (actually, cocoa from Ghana is a primary source of world famous Swiss chocolate). When Opportunity Cost is lower for an area of industry, economies will naturally take advantage and specialize. Because of this, goods and services will increasingly come from places where cost is lowest, and as long as a country has an advantage in one measure of industry, they will gain market share against their peers. This is Competitive Advantage in a nutshell.

What does this have to do with tariffs? Remember the definition I gave to tariffs, and how they are mostly used to protect nascent industry from bigger foreign competitors. This reason can be perverted easily, and stretched to mean the protection of any industry the domestic government sees fit to protect, even at the long term expense of its economy. The context of the 2018 world economy is a perfect example of where tariffs are neither necessary nor appropriate. The Trump administration levied a 25% tariff on foreign steel because it sees the preservation of U.S. steel manufacturing as a national security priority. It even went as far as to call steel imports from our strongest allies (Canada, the EU) a national security risk. Tariffs are unnecessary here because they drive up costs wastefully and without reason. Canada and the U.S. enjoy the largest peaceful border in world history, and have not been at war since the War of 1812. You would be hard pressed to find a more allied set of two individual nations, as evidenced by our cultural and athletic rivalries that could not be friendlier. If the U.S. can secure reliable steel imports from Canada at cheaper prices than in the U.S., then why would we want to raise those prices and increase expenses of every U.S. company that uses steel as a raw material? Would it not make more sense, from both a consumer standpoint and a long-term producer standpoint, to keep the inputs of manufactured goods as cheap as we can reasonably make them, and foster better relations with Canada so they keep reliably exporting to us? I digress. The point of this example is to illustrate that Canada is able to produce steel at less cost, so they have a Competitive Advantage in steel production. Instead of propping up our own steel industry, and possibly sacrificing a portion of our workforce that can be more productive elsewhere, we should instead rely on the cheaper good from a close and loyal ally, and use that savings to advance industries where we have advantage of our own (notable examples are Tech, Movies & Entertainment, and Military/Defense).

Third, in a world of ever-increasing globalization and competing world economies, tariffs do more harm than good. In the era of tariffs’ heyday, when the world was comprised of many individual countries that dealt with each other one on one, as opposed to in a group, hostile fiscal policy made more sense because it was used as a cudgel for a stronger economy to make a weaker economy do what it wanted. In case you didn’t know which era I’m talking about, it is the 1600’s – 1800’s. The great economies at that time, England, France, Holland, and Spain, all used economic hostility just as frequently as they used military hostility, to further their mercantilist goals of colonization and resource extraction. You may be aware that this era was comprised of many, many wars, and very few alliances or friendly relations. This was due in no small part to all the hostility between nations, in its various forms. Nowadays, the world is decidedly not that. The past 70+ years have seen rise to international and multilateral institutions previously unseen and unimagined, facilitating international development, financing, cooperation, and security. The effectiveness of these organizations is up to your personal interpretation, of course, but the world in general has taken great pains to make a world order than is without a doubt, one hundred percent not bilateral.

Why am I explaining all this? To drive the point home that bilateral economic relations is mostly a thing of the past, and attempts to further one nation’s agenda at the expense of a second nation will assuredly spill over and have negative effects with a third nation. To put it in a middle school context, other nations will talk behind our backs! If we slap a bunch of tariffs on China, for example, that drives the Chinese economy further from us. But if we also push away the Canadian economy, there is no rule saying Canada will be forced to deal with us and no other nation, regardless of how we treat them. Quite the contrary! China suddenly has more incentive to do business with Canada, since their economies are both further away from ours, and thus closer to each other. Who’s to say they won’t both levy tariffs of their own on U.S. exports, pushing up the world price of goods even further?

There have been a few notable examples of tariffs throughout American history, and the vast majority have been met with negative results on net. The most popular example is the Smoot-Hawley Tariff Act of 1930, meant to protect the profits of farmers suffering from the Dust Bowl. The Act set tariffs on foreign imports of agricultural products as high as 19%, pushing up domestic production and employment of agriculture in the short term. But US tariffs were already high at this time, and the additional tariff contributed to other countries’ rapid and substantial declines in global commerce. Obviously due to the Great Depression, the exact effects of the tariff were unclear, but the consensus is that Smoot-Hawley exacerbated its effects. Some notable statistics having to do with tariffs are, however, well documented. U.S. exports decreased 61% from 1929 to 1933 and Gross National Product fell 27% from 1929 to 1931. You don’t need me to tell you that the Great Depression was the worst economic event in modern history, but the tariffs certainly did not help, as foreign imports were discouraged in the U.S., which led to U.S. exports being discouraged in foreign countries.

Another example of tariffs in history is the Tariff of Abominations, enacted by Andrew Jackson in 1828. This tariff was a fixed 38% rate set on almost all foreign imports of products produced by the Northern states, so that they could compete with their British competitors. Again, this tariff produced more net negative than positive. By raising the prices of foreign goods to match domestic goods, the Northern states could compete on a level playing field in the domestic economy. However, the Southern states, which were not manufacturing states and relied on agrarian exports with cheaper foreign tools, suffered immensely due to a two-pronged effect. Their costs rose dramatically, while foreign countries they normally exported to would not accept as much of their exports due to perceived isolationism and unfair treatment. South Carolina in particular was hit so badly by this tariff, that in 1832, the state assembly approved a nullification measure, essentially saying that the states could choose to nullify any federal law they did not agree with. The ensuing clash over states’ rights and North vs South economies contributed in no small part to tension between the two sides of America, eventually leading to the civil war.

Finally, what about Dependency Theory? I’m no political scientist, but as I understand it, Dependency Theory is the emerging theory of international development that essentially splits the world into two types of nations. There are strong, sustainable nations, typically in the West and Europe, and smaller, weaker nations, typically found in Africa and East Asia. The growing inequality present in today’s rendition of capitalism causes the rich nations to grow richer on their own, and the poor nations to need the rich nations in order to get richer as well. So, the richer nations will turn this need into a predatory relationship, buying up natural resources and raw materials found in poorer nations for far cheaper than they would have had to pay to other richer nations. Since they pay the poorer nations far less than the resources are ‘worth’, poor nations only gain a small amount of wealth while rich nations keep the vast majority of their wealth. Tell me if this sounds familiar to you, because it should. This theory basically describes a modern version of Mercantilism, with poorer nations subject to ‘colonization’ by companies of richer nations, not unlike the East India Trading Company or the Hudson Bay Company belonging to England in the 1600’s.

The reason this theory comes to mind when talking about tariffs is because it gives a very good reason for tariffs to exist. If developing countries cannot sustain their own necessary industry, why would they allow themselves to be taken over by foreign developers and companies? Sure sounds good in theory, but again, it suffers the same fundamental negatives that we discussed already. Competitive Advantage is the cure for this. When I talked about Competitive Advantage above, I briefly brought up cocoa exports from Ghana, a small, developing African country. Despite having little in the way of manufacturing, a pegged currency, and a small population, cocoa exports from Ghana are the second largest exports of chocolate products in the world! Ghana happens to have several regions where rainfall is very heavy, and conducive to increased farming and production of cocoa and other chocolate products. As I mentioned, they export to famous chocolate producers like Switzerland, but they also export to and have beneficial trading relationships with the U.K. and Singapore. More facts about the cocoa exports of Ghana can be found here: https://www.cocobod.gh/

I’m not saying that Ghana’s cocoa exports are a perfect example of a country using competitive advantage to gain an edge in industry, but it is an example of how developing countries can effectively use this concept to compete with their foreign peers without limiting other industry. Countries like Ghana would do well to become friendlier with their neighbors, to pool resources for the common defense, and to promote commerce that is mutually beneficial and plays to all countries’ forms of advantage. In Ghana’s case, the African Union is a rapidly growing player in global trading blocs, and in a few decades, could become as important as the Association of South East Asian Nations (ASEAN) or even the European Union.

In summary, though I have not expressed my own opinion on whether tariffs are good or bad, I hope I have shown you that on the whole, tariffs are more negative than positive in a globalized, integrated economy like that of today. As with all things in economics, circumstances are never the same and everything should be taken with evidence. What’s important is that you make up your own mind using information readily available, and use your influence to make policy that better suits not only the U.S. population, but the population of the entire world. As always, thank you for reading, feel free to leave a comment or message me with any questions or concerns you have, and be sure to look out for more!

4 replies

Ian, awesome post on international trade! You are doing a service to our profession because your material is comprehensive, if you’re not knowledgeable in economics you explain it well enough that anyone can follow. Keep up the good work brother!

I hate to even mention this but it seems to me that the policy on tariffs is less to do with economics than it is about politics. In Freshman economics we’re taught about dead weight loss, so, I know his economic advisors let him know it was a bad idea but they’ve still pursued it. We’ve been told that this is a negotiating tactic but if the other side knows what you’re up to then how effective can that tactic be? If you’re China you know can wait until November to do anything or just a couple of years when the next presidential election is held. China’s economic policy for the better part of three decades has been for the long game, I wouldn’t put it past them if they’ve buttessed themselves for this scenario already. On negotiations, there are better ways to get your end, see “Getting To Yes”.

Last point, lol, based on comparative advantage a trade deficit is not a bad thing, that’s why everyone doesn’t try to grow their own food. Yes, there’s an outflow of money from the country most of which is reinvested in the U.S., it, in return, is getting a good or service for a whole lot cheaper than they would have if it had to produce those goods or services. The trade deficit is one aspect of the balance of trade, if we look at the capital flows aspect of it the U.S. runs a massive surplus to anyone, where else are going to get the highest return on your capital?

Thanks so much for the comment! I haven’t given my personal opinions on what’s going on in the post, but I completely agree that other countries, especially China, will simply play tit for tat with us and wait it out until a new administration. And yes, the vast majority of value of goods and services we purchase from other countries (our trade deficit) comes back to us in the form of cheaper investment. It’s reminiscent of a mercantilist, zero sum game view of the world system to think that having a deficit simply means we’re losing.

Hi, Ian
Since I am hardly well versed in economics, but well versed in common sense, it is clear that if a country places a trade barrier (i.e. tariff) on relations with other countries, political considerations (i.e. what keeps those in power in their lofty positions) demands a reciprocal “punishment”. Since demand for food and other essentials is likely to remain steady or increase with population increases, only sources of needed materials will shift to current lowest cost markets. But the cost is likely higher than before the tariff. The end result is higher cost to the end consumer, leading to lower demand for the product. If the product happens to be an essential so that demand cannot fall, then consumption of less essential products falls since most consumers have limited disposable income. The result? Overall, a damaged domestic economy. Enjoyed your analysis– it will need more “digestion” by this consumer. …………..Poppi

Thank you for reading! Yes, you are describing elasticity of goods and services, some are inelastic (like water) and most are elastic (like toothpaste/brushes, can be replaced with mouthwash or floss). You touched on my thought perfectly, as incomes do not rise (but actually fall, in Real terms) people will simply spend less.